Japan: Land of Rising Possibilities?
“Only a crisis, actual or perceived, produces real change. When the crisis occurs the actions that are taken depend on the ideas that are lying around.” -- Preface to "Capitalism and Freedom" Milton Friedman, 1982
Japan’s top political party, the Liberal Democratic party (LDP), may be on a bull hunt. Specifically, a group of LDP policymakers including former Prime Minister Shinzo Abe and ex- Finance Minister Koji Omi are assembling a raft of fiscal policy prescriptions to push the Nikkei back to 18,000 from its current level of 13,400 – almost a 34% increase. Put another way, a faction of Japanese policymakers in the LDP is now intent on restoring investor confidence, which has suffered immensely since peaking during July 2007, when the Nikkei traded at 18,002.
By grounding the discussion of fiscal policy to the Nikkei's performance, the LDP is elevating the market as the ultimate test of policy merit, which is a very helpful way of orienting the policy debate. Indeed, this may be the only way to get Japanese policymaking out of the thrall of zero-sum thinking -- where every tax cut must be offset by a tax increase or a spending cut --and into a more dynamic setting, where it is understood that faster economic growth and increased production often mean increased tax revenues.
This does not mean that the LDP has suddenly embraced the supply-side doctrine of the Laffer Curve, but latest indications are that some of these policymakers may be picking up the scent and heading down the trail. Among the most interesting proposals being reported by Bloomberg is the recommendation to abolish the taxation of capital gains and dividends. LDP legislators would like such an exemption to be in place temporarily, that is, until the Nikkei reaches 18,000. But they would like to expand existing exemption levels -- Y5million for capital gains and Y1million for dividends -- permanently. Similar to President Bush’s 2003 tax cuts, which temporarily reduced taxation on capital gains and dividends and thus helped the U.S. economy out of the post-9/11 economic downturn, the LDP’s suggestions could have a similar salubrious effect and breathe new life into the Nikkei, reinvigorate the economy and reverse the LDP’s political decline.
Were such an idea to pass, we could imagine the LDP's own attitude toward taxation evolving for the better; embracing the Tax Cutting Santa role as the Nikkei advanced and government revenues increased. Who knows, initial policy success might even mature to permanency. Such a scenario is only wishful thinking at this point. But it should not be ignored that some LDP policymakers, having suffered through the unprecedented loss of the Upper House during the 2007 elections, seem to be waking up to the realities of a more competitive political environment.
Today, the Democratic Party of Japan (DPJ), which holds control of Japan’s Upper House, seems poised to capitalize on the LDP’s sagging popularity and policy missteps. For example, the LDP is currently taking flak for its proposal to raise the gasoline tax for ten years, even as gas prices have risen in tandem with a yen that continues to weaken against oil, gold and other commodities. The unpopular proposal, opposed by the DPJ, is being pushed by the fiscal conservatives of the LDP to help close Japan’s $200+ billion budget gap. But more fiscal conservatism will not revive Japan’s moribund market nor is it likely to rev up sub-par economic growth.
This is why the tax exemption proposals on capital gains and dividends are so exciting. They represent the beginnings of a potential revolt against the party's fiscal conservatives, whose commitment to fiscal austerity is sending the party on the path to oblivion. Indeed, tax policy has been a growing weakness for the LDP. In the last half of 2007, the most significant proposal offered by the LDP-backed government was basically a zero-sum proposition centered around lowering Japan's corporate tax rate in exchange for a consumption tax hike to 10% from 5. According to PricewaterhouseCoopers the official corporate tax rate is 30%, but combined with local taxes the effective tax can be as high as 50%. The consumption tax increase proposal is a noxious idea, which has been kicked down the road by successive Prime Ministers since Junichiro Koizumi.
What's more, the proposal failed to address significant upcoming tax changes that are likely weighing on investors’ minds, such as the expiration of temporary tax cuts on capital gains and dividends, which would effectively raise rates to 20% from 10% by December 2008 and March 2009, respectively. How can the Nikkei mount any sort of sustained rally when taxes on capital gains are set to double? How would this permit the economy to grow more briskly?
To be sure, the Nikkei's current woes are not entirely derived from its hapless fiscal bind. After all, the market, like the S&P 500, is being affected by inflationary monetary policy (the yen) and ongoing troubles in international credit markets. But we applaud the group within the LDP that understands what is good for the Nikkei may also be good for Japan. And their willingness to seek market-friendly policies should be interpreted as a step in the right direction.
Although they may face stiff resistance from the LDP's diehard fiscal conservatives, we hope that the LDP faction now on the hunt for more market friendly policy proposals ultimately prevails. Even better would be for Japanese policymakers to abandon their attachment to zero-sum thinking -- which has exclusively fixated on closing budget shortfalls -- and look for ways to increase Japanese productivity and economic growth.
One of the best ways would be to increase the amount of capital relative to Japanese labor by permanently eliminating the taxation of capital gains altogether. Even if LDP lawmakers did so temporarily -- say 10 years to make up for Japan's lost decade of the 90s -- the resulting boost for the market and economy would improve Japan's fiscal situation and likely restore the LDP's dwindling political heft.
